People generalise to make sense of the world. Generalizations allow us to organize our thoughts and experiences, and to make predictions about new situations. It allows us to make decisions quickly and efficiently. However, there can be biases and inaccuracies. What we need is an approach that simplifies and yet, captures the essence.
Abstracting and simplifying “The Bull”
In December 1945, Picasso created The Bull, a series of 11 lithographs. With each successive print, a bull is simplified and abstracted. Picasso’s goal was to simplify The Bull down to its essence, to find, in his words, “the spirit of the beast”.
Starting from the flesh and bones – a depictive image of a bull, then the bull gained weight, and slowly started to turn into an abstract form. Picasso wanted each drawing in the series to be a successive stage in an investigation to find the absolute ‘spirit’ of the beast. It’s almost as though the artist is challenging himself. Finding out how much of the ‘bullness’ of the bull he can take away before it stops being recognisable as a bull. It’s finally only towards the end that we see the bull become a couple of lines – a great representation of absolute simplicity.
Simplicity wins. Simplicity is not, however, easy. Our human mind craves complex solutions for complex problems. It yearns to add bells and whistles at every opportunity. The more details and increased complexity make us less productive. With more information to consider, it creates analysis paralysis; resulting in stress and anxiety. We need to find the balance.
Generalisation accuracy and biases
Many investors generalise as a shortcut to their evaluation and due diligence. While generalization can be a useful cognitive tool, it can also be potentially dangerous in certain situations; where we simplify and abstract to an extent that it does not have the “essence of the bull”.
- Oversimplification: Generalizing can lead to oversimplification, where complex and nuanced phenomena are reduced to broad statements or stereotypes. This oversimplification can result in a distorted or incomplete understanding of reality. People and situations are often more diverse and varied than generalizations imply, and failing to recognize this can lead to misunderstandings, biases, and unfair judgments.
- Stereotyping and Prejudice: Generalizations can contribute to the formation and perpetuation of stereotypes, which are oversimplified beliefs or assumptions about a group of people. Stereotypes often involve making generalizations based on limited information or biases, leading to prejudice and discrimination. This can harm individuals and perpetuate social inequalities.
- Misrepresentation: Simplification can inadvertently misrepresent or distort the true nature of a topic. By condensing or omitting certain aspects, the simplified version may not capture the full complexity or context of the subject. This can lead to misconceptions, misinterpretations, and a shallow understanding of the topic at hand.
- Ignoring Individual Differences: When we generalize, we tend to overlook the unique characteristics and experiences of individuals. People have different backgrounds, perspectives, and circumstances that can significantly influence their behaviour or outcomes. By ignoring these individual differences, generalizations may fail to capture the complexity and diversity within a group or population.
- Inaccurate Conclusions: Generalizing from a limited or unrepresentative sample can lead to inaccurate or misleading conclusions. Drawing sweeping statements based on a few instances or a biased subset of data can result in flawed judgments. It is crucial to consider the variability and context of the information before making broad generalizations.
Examples of generalisations in investing:
- Rising interest rates are bad for REITs.
- Electric vehicles and artificial intelligence represent the future, or
Electric vehicles and artificial intelligence are hype. - China stocks are uninvestable.
- Singapore stocks are boring.
- Debts are bad!
Consciously or unconsciously, these generalisations act as screeners, for better or worse. Are these generalisations reliable? Are they good filters? They may be accurate at some point in time.
When we generalise and simplify, how do we ensure that we are still able to capture “the essence of the bull” (and not any other animals)?
The metrics for investing
Picasso’s approach to abstraction and ability to capture ‘the essence’ of “The Bull” is equally applicable to investing (and many other aspects of life). How can we identify high-quality companies to invest in with a few metrics? What are these metrics? How do we ensure that these metrics are reliable?
High-quality companies do have common characteristics and these are traces to identify other high-quality companies. Investors and academics have been studying to find these traits.
Know what to draw and know the bull to draw the bull
First things first, it is always good for the investors to be familiar with the sector and the company, the long-term attractiveness and potential, how the company makes money, what has fueled the growth to date and the key success factors. This can be done before or after identifying the companies with the metrics. Having a good understanding of the sector and company allows us to have a better understanding of the metrics and what they are measuring.
Metrics
Below are my key metrics to identify high-quality companies:
| 1. Consistent revenue and profit growth | A good company must be capable of growing its revenue and profit consistently. The ability to grow and generate a good free cash flow margin consistently is the reason why the share price will appreciate. |
| 2. Ability to maintain/ increase gross and operating margins | The ability to maintain/increase indicates pricing power, operating leverage and economies of scale as the company grows. Do note that different industries will have different margins. |
| 3. Ability to maintain/increase free cash flow margin (FCF to revenue) | The litmus test of any companies is its ability to turn growing revenue and profits into a growing cash machine. A business must make money period (ultimately). As a company grow its revenue and profits, it has to be able to generate more cash correspondingly. |
| 4. High/increasing Return on Invested Capital (ROIC) / Return on Equity (ROE) / Return on Capital Employed (ROCE) | The company must be able to generate good returns from its capital consistently. The returns may vary with different sectors. ROIC is one metric that many are advocating. Michael Mauboussin has been publishing many papers on ROIC. |
| 5. Gearing ratio and interest coverage | We need to ensure that the company’s debt level and interest coverage are manageable and will not cripple the company. This is crucial during unexpected economic crises and rising interest rates where revenue may drop and customers may delay payments, affecting its cash flow. The metrics are not relevant if the company is in a net cash position. Hence, I prefer companies in a net cash position so that I have one less metric to worry about. |
Next, we compare the above-mentioned metrics to those of their competitors to determine their relative competitive position.
| Growing faster and better than competitors | Compare with their competitors on whether the competitive gaps are widening or narrowing The comparison allows a more objective understanding of the competitive position of the company vis-a-vis its competitors. |
A key criterion is consistency; the metrics have to be growing in the right direction in a consistent manner.
From the metrics, we will want to examine further what they have been doing to achieve such results; linking the metrics to their strategies and plans to the outcomes.
How the metrics capture the “essence of the bull”:
The value of a high-quality company is its ability to grow revenue consistently and maintain/increase gross and net margins to generate free cash flow after a portion of operating cash flow allocating to reinvestment to keep building its moat and grow its business above its costs of capital. The share price will rise to reflect its growth and potential. The strength and durability of its competitive advantage (moat) are important which are reflected in the metrics.
To ensure the reliability, we should keep validating our metrics (trace the path of successful companies and the market cycles). This helps to reduce biases and inaccuracies. It is a process of continuous learning and improvement.
Below is an example of Sheng Siong; a supermarket chain operating in Singapore.
Consistent growth in revenue, profits and free cash flow in a net cash position
Its operating margin has been inching higher while its competitors are declining.
Tesla and Amazon are good examples of how they have grown over the years.
The section on Deep Dives of the blog showcases high-quality companies in greater detail using the above-mentioned metrics.
Considerations
Here are some considerations when applying the metrics:
- How long a time period do you want to review to ascertain the extent of consistency and be convinced to invest?
A shorter period can be less reliable; the company may not experience different situations and prove its mettle.
Too long a period will have successful companies growing big and the share price appreciated substantially. There may be less room to grow and growth may taper.
A 3-to-5-year period is a good time frame. Currently, I prefer a 5-year timeframe as COVID-19 has “distorted” the trend and it is also a good period to study its resiliency and adaptability. - What is the threshold?
Depending on personal preferences and the sector/company, select a growth rate (high-growth, low-growth) that you are comfortable with. A higher growth rate usually means a more expensive valuation and a more volatile share price. - Not all metrics are ticked.
For investors who are interested in younger high-growth companies to find the next Amazon and Tesla, they may not be profitable, ROE/ROIC become negative and difficult to ascertain their valuation.
The more metrics not ticked, the more abstract and more difficult to determine the quality of the companies (harder to ascertain the “spirit of the bull”).
We have to decide how stringent our metrics and how unreliable will our metrics be if we are less stringent. It is a trade-off. - How tolerant are you when they miss the metrics?
There will be economic cycles that affect the company. The company may make some mistakes. It can also be situations where competitors are catching up and/or customers are slowing down their purchases.
As the metrics drop, keep a look out for any signs of further deterioration and possible actions required. It can be a trim, sale or maybe add if we believe it is temporary. - Other than US stocks, many sites do not provide FCF margin, ROIC and ROCE for stocks listed in other stock exchanges.
- There are different ways to calculate free cash flows, ROIC and ROCE. So, it is not good to compare them across different sites.
There is no one-size-fits-all approach to investing. We “draw our bull” differently. Everyone is different in circumstances, risk appetites, temperaments, emotions, preferences, needs, priorities, goals, levels of understanding and experience in finance, investment, and money management. We invest differently.
Also, there are many different companies in different sectors and countries at different lifecycle stages that we can invest in. We can adjust these above-mentioned metrics or have our own metrics to fit our individual needs and objectives. We need to keep learning and improving our set of metrics; our own approach to capture “the spirit of the beast”.
Below are some materials that explain the metrics to identify high-quality companies:
- Multi-baggers with growth companies
- Our Investment Philosophy by Chuck Akre (“three-legged stool”)
- 100 Baggers: Stocks That Return 100-to-1 and How To Find Them by Christopher Mayer
- The Warren Buffett Way by Robert G. Hagstrom
- What I learned about investing from Darwin by Pulak Prasad
- ROIC and the Investment Process, 6 June 2023, Michael J. Mauboussin
- Great learnings – Investing
- What you need to know about Return On Invested Capital
- All Revenue is Not Created Equal: The Keys to the 10X Revenue Club
- Why return on invested capital is the most important investing metric, John Rotonti, Motley Fool, May 25, 2022
- Companies with high free cash flow margins and high free cash flow yields massively outperform the market over time, John Rotonti, Motley Fool, June 29, 2022
